Sunday, March 08, 2009

Economic crisis and interest rates

It is obvious that we are in the midst of an economic crisis. Though some economists are apprehensive that the situation will deteriorate further and we will drift into depression akin to the Great Depression (1929-33), most analysts are less pessimistic and are of the view that the problem is only a recession in some economies like the US and the UK and a slowdown in countries like India and China.

Whatever be the diagnosis, the ailment calls for urgent remedial steps. Recession is theoretically defined as fall in Gross Domestic Product or National Income in two consecutive quarters. Recession may be either cyclical or structural. Economies undergo expansion and contraction alternately. If cyclical contraction is severe and prolongs over a minimum of two quarters, it leads to cyclical recession. On the other hand, if misallocation of resources among various competing sectors in the economy results in recession, we call it as structural recession. Misguided economic policies culminate in asset bubbles causing mispricing of assets like real estate,stocks and shares and commodities.

If we look at the origin of the present global economic meltdown, it all started with the drastic fall in real estate prices in America. Market prices of houses in America were earlier recording vertiginous rise year after year because of cheap availability of credit. Continual increase in house prices resulted in positive "wealth effect" stimulating even higher growth in overall consumption demand. Economy was growing on the unsustainable combination of low savings and high consumption which was typical of American culture. When the house price bubble burst, consumption demand was adversely affected and the hunky-dory days came to an end.

Whereas opinion is divided on whether the recession is cyclical or structural, the intensity and recalcitrance of sluggishness in demand indicate that it is a hybrid of the two. Therefore, urgent fiscal and monetary measures are desperately needed to reflate the economy. It is in this background that governments and central banking authorities in various countries are implementing different stimulus packages and an accommodative monetary policy. Ironically, many economists who had traditionally placed 'market mechanism' on a high pedestal and abhorred nationalisation of any kind are now advocating a crucial role for the state to revive the moribund economy. They are even recommending nationalisation of banks to rescue the battered banks and the effete economy. How times have changed !

As RBI has eloquently observed, "Even as policy responses across countries are broadly similar, their precise design,quantum,sequencing and timing have varied".One common policy measure adopted by all countries so far has been to reduce interest rates.It is hoped that the fall in interest rates will encourage borrowings for scaling up production in the real sector and for purchase of houses,cars etc.If more liquidity is released in the economy, consumption also will increase.Thus, supply as well as demand for goods will spiral up, buttressing the economy in the process.Fed rates have been reduced to as low as 0.25% in the US. RBI has pruned the repo rate (the interest rate at which commercial banks can borrow from RBI by pledging G-Secs) from 9% to 5.5% in the space of just one quarter.Though there has been persistent demand from industry to reduce rates further, RBI has wisely refrained from effecting more cuts atleast for the present, while releasing the third quarter review of Monetary Policy recently.

What are the factors to be considered before scaling down interest rates? Interest rates impact various economic indicators like supply and demand for goods and services, exchange value of the rupee, savings culture and inflation prospects. From April 2008 to January 2009, rupee has depreciated against the US Dollar, Japanese Yen and Euro.It has marginally appreciated against Pound Sterling.The rupee underwent precipitous depreciation during February and has worryingly breached the psychological Rs.50 to a Dollar.Further reduction in interest rates in India will only exacerbate the weakness of the rupee.